The Investor's Dilemma Decoded

Few aspects of life are as important as personal finance, as subject to your control, and as suffused with misinformation, noise, and confusion. Now, authors Dr. Roger D. Silk and Katherine A. Silk cut through that confusion and share with you the fruits of their knowledge and experience developed over the last 43 years. After completing a Ph.D. at Stanford where he studied at the cutting edge of finance theory, Dr. Silk's experience includes managing billions of dollars at the World Bank and running a family office for one of the nation's wealthiest families. For the last 26 years as CEO of the nation's leading firm which advises high net worth individuals on financial and other aspects of their philanthropy, Dr. Silk has worked with countless individual investors and financial professionals. Katherine Silk, who holds a master's in history from Stanford, adds a valuable and often-missing historical perspective. Their weekly blog, dealing in depth with a variety of financial, economic, and planning issues, is read by thousands. Unlike many authors in the Personal Finance space, the Silks have the deep technical expertise (it's hard to get a graduate degree from Stanford without it), decades of experience, and the rare ability to express complex ideas in clear, easy-to-understand prose. When Gary Taubes wrote The Case for Keto, he considered calling it “How to Think About How to Eat.” Similarly, The Investor's Dilemma Decoded could be titled “How to Think about How to Invest.” Investor's Dilemma gives you the tools that 99.9% of investors never master — these tools allow you to understand how to think about almost any category of investment, and almost any investment product or program. In addition, the authors take a deep dive into topics including What actually generates investment returns (it's probably not what you think) Is owning a home an investment (you'll learn why the answer is sometimes yes, and sometimes no) Should you own gold (clue: the largest gold holders in the world are central banks) What is a hedge, and are commodity funds an inflation hedge What many well-known investment personalities get wrong on about returns (they tell the truth, but it's the wrong truth) What risk is, and isn't, and why the “safe” course might be the riskiest (but the government says it's safe). How professional financial advisors can add huge value to their individual clients (it's not by picking the best stocks) Should you read this book? If you want to understand how professionals think about investing, about what is realistic and unrealistic, and learn to spot the difference between a Bull Market and Bull-xxxx, the answer is yes.

Synopsis of The Investor’s Dilemma Decoded xv Acknowledgments xix Introduction xxi Chapter 1: Time Value of Money 1 The Standard Theory 1 Assumption: You Can Save Money at No Cost 2 Assumption: You Can Save Money at No Risk 3 Time Value of Money and Compound Growth 4 Comparing Values Across Time 6 Real-World Compounding Versus “Pure” Theory of Time Value of Money 6 Appendix 8 The Math of Compounding 8 More Frequent Compounding 8 Exercises 11 Answers 12 Chapter 2: Basic Investment Analysis 13 Basic Terminology 13 Modeling an Investment as a Series of Cash Flows 14 Net Present Value 15 Valuing a Stream of Cash Flows 17 Easy Way 18 Harder Way 18 Present Value of a Growing Perpetual Stream of Cash Flows 20 Duration: A Measure of Interest Rate Sensitivity 21 How Is Rate of Return Calculated? 23 Simple Annual Rate of Return Versus Compound Rate of Return 23 Arithmetic Versus Geometric Mean 24 Appendix 26 Internal Rate of Return 26 IRR Defined 26 Some Limitations of IRR 27 Chapter 3: Bonds/Fixed Income/Loans 31 Bonds 31 What Are Bonds? 31 Bond Terms 32 What Determines Bond Returns? 32 Return Versus Yield 33 Short to Medium Term 34 Inflation Adjusted or “Real” Returns 38 Risks to Bonds 41 Credit Risk 41 Historical Experience of Defaults 44 Interest Rate Risk 46 Bond Math – The Absolute Minimum 46 Inflation Risk 48 Low Interest Rates as Financial Repression 50 Chapter 4: Equities 51 What Are Equities? 51 Equity 52 Additional Equity or Equity-Like Asset Classes That Might Be of Interest 53 What Generates Stock Returns 53 Medium- and Short-Run Returns 55 Individual Stocks Versus “The Market” 56 Markets and Indices 56 Valuation Measures for Individual Companies 57 Valuation Changes and Returns 59 Noise – Information Versus Signal 60 Valuation Changes 61 Historic CAPE Versus Returns 61 What About Momentum? 62 What Has Generated Historical Returns in the US Market? 64 Long-Run Source of Returns to US Stocks 65 What Returns Can We Expect from US Stocks from Here? 66 Valuation Risk 69 Medium-Term Expected Returns 69 Variability 70 Takeaways Regarding Returns 72 Chapter 5: Real Estate 73 Kinds of Real Estate 74 Farmland 74 Falling Interest Rates Explain Half the Real Increase Since 1967 . . . 76 . . . But Falling Interest Rates Explain All the Real Increase Since 1987 76 Price/Earnings Ratio for Farmland 76 All Farmland 78 Farmland – Summary 80 Longer-Term Returns to Farmland 80 What Returns Should We Expect from Farmland? 84 Timber 85 Office Buildings 85 Returns to Land 86 Homes 88 Owning Apartments as Investments 90 Source of Return 90 Economic Theory 91 Summary 96 Chapter 6: Gold and Gold Stocks 99 Is Gold in a Class by Itself? 99 A Brief History of Gold 100 Gold’s Place in a Portfolio 104 What About Gold Stocks? 106 Silver 107 Summary 108 Chapter 7: Futures and Commodities 111 Arbitrage 111 Futures Contracts 112 Pricing of Futures Contracts 113 Commodities 116 Monetary Regime Matters 122 Are There Commodity “Yields”? 123 Collateral Yield 126 Commodity Index Funds Have Negative Expected Real Returns 127 Managed Futures Funds 127 Barclays CTA Index 129 Chapter 8: Mutual Funds 133 Open-Ended Funds Versus Exchange Traded-Funds (ETFs) 133 Advantages of Fund Investing 134 Index Funds 134 Sector Funds 135 Hedge Funds 136 Individual Bonds Versus Bond Mutual Funds 136 Are Mutual Fund Expenses a Good Value? 137 Chapter 9: Basic Portfolio Theory 139 Markowitz Model 139 Capital Asset Pricing Model 142 How and Why Diversification Can Reduce Risk 143 Mathematical Underpinnings of the Capital Asset Pricing Model 144 Don’t Mistake Beta (Returns Correlated with Risk) for Alpha (Risk-Free Returns) 146 Assessing the Risks and Returns of the QQQ Versus the Spy 147 Drawdowns 149 Random Walk 150 Efficient Market Hypothesis 151 Significant Exception to the Efficient Market Hypothesis: The “Value Anomaly” 154 Value Versus Growth Stocks 154 International Evidence 155 What About the “Size” Effect? 157 “Cheap” or “Expensive”? Volatility of Stock Prices Versus Earnings or Dividends 158 Can You “Beat the Market”? 159 Why Don’t Professionals Beat the Average? 160 Effect of Fees 160 Effect of Cash Holdings 160 Enhanced Index Strategies 161 Which Index? 163 Conclusion 164 Chapter 10: Financial Leverage 165 Reg. T. 166 Effect of Leverage 166 Securities Lending 169 Payments in Lieu of Dividends 169 Securities Lending Is a Complicated Tax Area 170 Rehypothecation Risk 171 Real World Leverage, Again 172 Chapter 11: Risk 175 Fear of Losing Money 175 Risk Versus Uncertainty 175 History 177 Using Statistics to Understand Risk 179 Explanation – Arithmetic and Geometric Means 179 So What? 181 Variance 182 Another Important Implication of Volatility 183 Modeling Likely Future Values 184 Modeling Future Wealth 184 Mathematical Approach – A Very Short Course in Statistics 185 Sample Mean 186 Standard Deviation 186 Population Standard Deviation Versus Sample Standard Deviation 188 Standard Error 188 Standard Error and DMS 189 Projecting the Likely Range of Future Values 190 Skewness 191 Percentiles 192 Expected Value Revisited 194 Chapter 12: Assembling a Portfolio 195 Forget About “Best” or “Optimal” 196 Reasonable Estimates for Expected Returns – Equities 197 Two Defensible Ways of Estimating Expected Returns 198 “Naïve” Long-Run Historical Average 198 Historical 201 Argument for Continued Outperformance 202 Argument Against Continued Outperformance 202 Role of Valuation 203 Valuation-Based Expected Return for Equities 203 Other Valuation Approaches 206 The Price/Book “Formula” 207 Expected Return 207 Our Preferred Methods 208 Reasonable Estimates for Expected Volatility 208 Time Frame 208 The VIX 209 Implied Versus Realized 210 The Case for 20% Long-Run Stock Market Volatility 211 Expected Returns and Volatility – Bonds 212 Expected Returns and Volatility – Cash 212 Expected Return and Volatility – Gold 213 Expected Return and Volatility – Gold Stocks 214 Expected Return and Volatility – Managed Futures 214 Cautions 216 Expected Returns and Volatility – Real Estate 218 Covariance Matrix 219 What Covariances/Correlations to Use 220 Covariances and Portfolio Formation 221 Stock Market Return Correlations Over Time 222 Calculating Expected Returns and Volatilities for a Multi-Asset Portfolio 225 Calculating the Return and Variance of a Portfolio 226 Return 226 Variance (Volatility) 226 Example with Six Assets 227 Matrix Algebra 228 Expected Returns 229 Variance 230 Chapter 13: Portfolio Simulations 233 Simulating a Variety of Portfolios Based on Cash and the World Equity Market 233 Portfolio 0 235 Implications 243 Conclusion 246 Chapter 14: Professional Advice 247 Personal Financial Planners 248 Who Should Consider Professional Advice 248 Financial Literacy 249 FINRA’s Quiz 249 Interpreting the FINRA Quiz 251 Numeracy 252 Aside on the Rule of 72 252 Financial Literacy and Professional Advice 253 How Professionals Add Value 254 How Much Value Financial Planners Add 255 Planner Value Added – “Gamma” 256 Factors to Consider When Selecting an Advisor 257 Alpha 258 Beta 258 Gamma 258 Advisor Characteristics 259 Integrity 259 Incentives 260 Skill 260 Personality 261 Checklist 263 Chapter 15: From Theory to Practice 265 Appendix: Some Math of Diversification 269 Variance 269 Standard Deviation 270 Examples Using Bet of Coin Flip with Positive Expected Value 271 Independent Events – The Key to Reducing Risk 273 Random Variables 274 Binomial Distribution 276 Normal Distribution 277 Covariance 278 Sum of Variances 279 Binomial Expansion 280 Weights 280 Variance of a Portfolio 281 Correlation Coefficient 281 Demonstration That If Assets Are Correlated, Risk Can Never Be Eliminated 282 How Much Diversification Is Enough? 283 Equal Weighting Versus Market Capitalization Weighting 285 Reasons to Prefer Equal Weighting 286 Theory 286 Market-Capitalization Weighting 288 Market-Cap Weighting and Statistical Bias 289 Diversification Within an Asset Class and Between Asset Classes 290 Within an Asset Class 290 Unified Asset Classes 290 Gold 290 Treasury Bills and Money Market Instruments 291 Sovereign Government Own-Fiat-Money Bonds 291 Dispersed Asset Classes 292 Bonds 292 Theoretical Example of Diversifying Bond Default Risk 292 Asymmetrical Risk 294 Stocks 294 Across How Many Stock Markets Should You Diversify? 294 How Stable Are the Parameters? 298 Conclusions: How Many Countries? 299 Statistical Normality 299 How Many Stocks Within a Country? 302 Median Expected Return 303 The Effect of Errors in Parameter Estimation 306 Error in Estimation 306 Another Point of View 307 Index 311 Three Free Offers for Readers 339